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The Heat

Summer is here, and the heat is on.  A quick glance at the weather map shows vast portions of the country shaded dark red reflecting temperatures north of 95 degrees.  The National Weather Service is expecting temperatures in New York to top 90 degrees for the next seven days, something that apparently happens only once every 30 years.Extreme temperatures in Chicago led to hosing down the Michigan Avenue bridge in order to cool it to the point the expanded steel would once again lift to allow boats to pass.  In a replay of last fall, raging wild fires have struck in California, Colorado, Utah and New Mexico.

Communities in the west are mandating water restrictions due to the eerily low snow pack from the past winter and low rain fall.  Climate change and the associated heat is compounding the existing water crisis. The High Plains Aquifer in eastern Colorado is drying up.  The Denver Post reviewed federal data showing the aquifer shrank twice as fast over the past six years compared with the past 60 (Denver Post, 8/10/17).The problems associated with agricultural over-pumping, farming drought-prone prairie land, increasing development and demand for natural foods is overwhelming the limited water supply.  If all pumping stopped immediately, it would still take hundreds of years for rain-fed streams and rivers to recharge the aquifer.

Theatmosphere surrounding the stock market is tense and selling bouts are sharp.  While year to date returnsremain positive at 2.65%, measured by the S&P 500, its becomingever more uncomfortable.  There has been pronounced selling, particularly by fund and ETF holders.  To date, this has been more than offset by companies repurchasing their own shares.  There were $433.6 billion in share repurchases during the period, nearly doubling the previous record of $242.1 billion in the first quarter, according to market research firm TrimTabs.  The buying has supported returns, but it cannot last.

The stock market continues to favor high growth stocks over dividend or value plays.  We pay close attention to these trends and it has been favorable for our style of investing.  According to Bloomberg, more than 100% of the S&P 500’s year to date total return is attributable to just 10 stocks, including Amazon, Microsoft, Apple, Facebook, Visa, Adobe and Nvidia.  These are all large cap growth stocks we have owned for a number of years and our positioning has provided us with an attractive tail-wind.

The key questionis, how credible is the threat to the current $175 per share in earnings forecast for 2019.  As the trade war continues to escalate, expected earnings figures will inevitably begin to be talked down by analysts.  We may encounter this as early as the 2Q reporting season beginning later in July.  U.S. corporate tax receipts, according the U.S. Bureau of Economic Analysis, have fallen by over 30% since the same time last year.  Will our ballooning debt lead to higher interest rates, and a rate induced deceleration?

Another important measure is the yield curve. The economy is heated up, with slackening regulations, reduced taxes and a frothy mindset on Wall Street.  The Federal Reserve has been steadily raising rates, and this has flattened the yield curve.   The spread between the U.S. 10-year and the 2-year is now a mere 0.28%.  An inverted yield curve is a widely accepted (and often self-fulfilling) indicator of a recession. A recession is a period when both economic activity and trade are in decline.  This leads to declining corporate earnings, which in turn pulls stock prices down.

So here we are, in the hot-seat.  Atsome point the winds will change and we will have to make some tactical adjustments to the portfolios.  It’s not at all clear when, but things will change, as they always do.  Until then I suggest we try to become more comfortable with the heat, the volatility and the seemingly incessant flow of fiction dressed as news.  I may look in the attic for the old Ouija board to see if we can derive any clearer signals (just kidding).  In the mean time I hope you have found a cool and comfortable place to enjoy some fireworks, in the true sense.  Happy 4th of July.  Please feel free to call if we have not been in touch recently.

Bruce Hotaling, CFA

Managing Partner

Change is Coming

The stock market is all about earnings.  Corporate earnings and their level in relation to stock prices is the fundamental basis, the keystone, of stock valuation.  US stocks have been enjoying an unprecedented period of earnings growth and price appreciation.  Much of this stems from the stock friendly behavior coming out of Washington DC.  In general, corporate America could not be more pleased with the US corporate tax cuts and the across the board emphasis on de-regulation.

For the month of May, this symbiotic relationship continued to self-reinforce, and stocks responded with a total return of 2.41%.  The solid returns for the month brought the S&P back into the black for the year.  May’s positive returns and moderate volatility (only three of 21 trading days had price moves +/- 1%) were a welcome relief for investors after two stressful months with sharply negative returns in February and March.

While stock returns are modestly positive this year, it’s a shadow of the 8.8% return through May of 2017.   I do not expect the S&P 500 to return 22% again this year.  Signs of trouble are brewing.  Few asset classes are faring well.  Most larger foreign markets are down (Brazil -11.9%, Germany -4.2%, China -4.6%).  Gold and silver, and almost every maturity level across the fixed income spectrum are also down year to date.

It’s a challenge to make forward looking determinations on how best to position the portfolios in the face of so much media noise and misplaced commentary.  In my opinion, there are two overhangs to the market that are threatening to spoil what has been an intoxicating run for stock investors.

One of the supportive backdrops for the upbeat market in 2017 into 2018 has been coordinated global growth.  The idea behind this concept is a stronger global economy supports improving demand for US goods and services, and spurs corporate profits.  The US$ had been low, amplifying the effect.  Suddenly, this growth driver is under assault, and isolationism and protectionism are on the rise.

Further, tension on the Korean peninsula, threats of a trade war with China, tariffs on steel and aluminum imports from Canada, Mexico and the Eurozone, and the US’s withdrawal from the Iran nuclear deal have led to a destabilization of the world political-economic order.  This is thin ice.

Much of the anticipated global growth was fueled by debt.  Now, global debt has reached levels never seen before, equivalent to 225% of global GDP (according to the Economist 4/24/2018). China is guilty of leveraging up to sustain its economic growth.  This is similar to the US tax cuts that will push the US deficit over the $1 trillion mark.  Emerging markets are suffering with many of their obligations issued in US$s (Argentina, Turkey).  Growth, measured by GDP has slowed.  The question here is whether we have come to that point, the tipping point, when things begin to change, while no one wants to believe that is truly the case.

The question isn’t so much if there will be trouble, but when.  I do not think any changes in asset allocation need to be made, yet.  I do expect returns to bonds to be minimal, and stocks to be in the average range.  I am pleased the market continues to reward growth over value.  This is a tailwind for our portfolios.  Our core approach to investing is referred to as GARP or growth at a reasonable price.  Growth stocks continue to outperform value stocks at the large, mid and small cap levels, by notable margins.  The two highest returning sectors are technology and consumer discretionary, both sectors where we hold overweight positions. 

One of the clearest reasons to take a more cautious posture toward stock investing is because many, possibly too many investors and market commentators are overwhelmingly positive.  They tend to tick down the list of supportive economic or consumer data points.  There is a lot of cool-aid being consumed out there.  I’m not a contrarian, but I’m also not one to get sucked into the vortex.  The best course of action today is to avoid getting drawn in to owning too much stock.  We need to stay well invested, while hovering one foot over the break. 

Bruce Hotaling, CFA

Managing Partner

Rock Steady

April was a “backing and filling” month for investors.  This is a stock market term that applies to prices as they attempt to digest a large run up.   After a monstrous 5.6% jump in prices in January, the return to stocks in April, measured by the S&P 500, was a mere 0.27%.  Year to date, returns have fizzled and are now down 0.38%.    These results mask some eye catching day to day price moves.  For example, out of the 21 trading days in the month, 9 involved an up or down move in prices of greater than 1%.

This volatile yet sideways pattern is likely a byproduct of last years extended rally in stock prices that led so many investors to the trough of complacency.  Fifteen months of positive returns will attract a lot of attention – suddenly investors began chasing returns, and taking on more risk.  It had become too easy.  A reflection of this mindset was the craze over bitcoin.  That was an extension of the high risk-taking mentality that consumed investors worldwide.

On January 26th, stock prices hit their 14th record high of the year.  Over the next couple of weeks we experienced a full on reversal of the prior year’s blind optimism and things turned ugly.  By February 9th, stock prices had fallen over 10% on an intra-day basis.  The dust settled, and things seemed ok, until April 2nd when prices went right back down to those uncomfortable levels.       The origins of this sudden shift in market direction initiated a raft of media speculation as to what might have gone wrong.  Was it the US 10-year Treasury nearing 3%, the looming Federal Reserve interest rate hikes or possibly saber-rattling talk from Washington about trade wars?  When market trends change, it is often unclear what precipitated the change.  For us, the more important question is the emerging trend – what does the slope of the developing trend in prices look like?

As an investor, it’s important to focus on and identify investment goals, particularly long term.  The big considerations are, what are we working toward and what is the best path to get there?   Trouble often shows itself in the short term.  While things that come up admittedly do not normally have any bearing on long term goals, or the agreed upon path, they can be un-nerving to the point investors retreat.  There are times when owning stocks is flat out uncomfortable. 

After years advising people how best to position their financial assets, one thing clear to me is how easy it is for investors to become disillusioned.  Admittedly, there is some concern the world at large is sliding down a slippery slope.  This may be true, or it may not.  In my opinion, though we perceive a tenuous backdrop today, there has always been a long list of things that could go wrong.  Often, we did not know there was a monster under the bed.  I suspect our current cautious awareness puts us in a better position to look ahead and acknowledge risk.  Stocks are inherently high risk, high return, and when investors dismiss this we are collectively on thin ice.

Our goal is to guide our investors in a way that allows them to hold quality investments during challenging times.   As active investment managers, this requires our constant attention and a balance of art and science.  We use analytical tools and fundamental analysis, along with a considerable dose of experience.  We also use a risk-on, risk-off approach to profit during the good times and temper the effect of the difficult periods.  This is in stark contrast to passive index strategies or a blind reliance on asset allocation models. 

My expectations are for the recent surge in volatility to continue, though tempered somewhat.  I also expect stock prices to move higher by the end of the year.  Earnings have been strong through the first quarter and analysts’ forecasts through the year-end are high.  I do not expect stocks to deliver anything close to the 20%+ returns we saw in 2017.  Considering the backdrop, we ought to expect it to remain challenging.  We are constantly asking whether the choices we are making today are additive to your long term goals.  At the moment, I am optimistic we are well positioned for the year ahead, but I am also prepared to change course if need be.  I invite you to call if you have concerns.

 

Bruce Hotaling, CFA

Managing Partner

Nor’easter

Let’s hope March of 2018 was an anomaly.  Just as signs of spring were beginning to appear, folks living in the northeast and mid-Atlantic encountered what was likely their first ever cyclone bomb.  Exhausted from shoveling snow, they were then clobbered by three more nor’easters in a three week span.  It could be we need to place more trust in Punxsutawney Phil’s early February predictions. 

The unpredictable nature of these storms reflects closely the unsettled activity in Washington, which is becoming so chaotic it looks to be finally having the effect on financial markets many had feared back in November 2016.  Stock prices, measured by the S&P 500, have begun to mimic both the unforgiving nature of recent weather – and the chaos inside the beltway.  Stocks fell in March by 2.7%.  This is on the heels of a 3.9% decline in February.  Year to date, stock prices are down 0.76%.

For some context, over the last 30 years, the S&P 500 has produced an average return of 12.2%, with an annual standard deviation of 17.3%.  There have been 5 years (17% of the time) when the return to stocks was negative, and in those years, stock prices fell on average 16.6%.  After a larger than average 21.8% return in 2017, stock prices may be reverting to the mean.

On a more granular level, the stock market looks to be attempting to assess the potential damage from a trade war.  Old school protectionism is the latest contrivance out of Washington in hopes of making America great again.   Restrictive trade, whether it leads to a trade war, will put the brakes on the positive effect foreign competition has on holding down price inflation.

The recent stock price volatility highlights the concern that fractured global supply chains may negatively impact US corporate margins.  Free trade is proven to stimulate economic growth.  Higher tariffs will eliminate the process of comparative advantage that allows all parties to benefit from globalization.  If the root of the problem is infringement of intellectual property rights, then that needs to be addressed directly, without the random and damaging effects of trade warfare.               

Recent economic data has not been compelling and the nine year expansion is long in the tooth.   Employment levels are high, so high investors have been on alert for signs of inflation.  The brutal stock sell-off in early February was ignited due to clear signs of inflation based on reports of increasing wages.  Stock investors are well aware, if a cycle of higher inflation has begun, the Fed will continue to raise interest rates.

The yield curve has shifted upward, and flattened.  This is a mixed signal.  It may well be telling us growth expectations have deteriorated.  The Federal Reserve has raised rates now for the sixth time since the first 0.25% hike in mid-2015.  Expectations are for 3 hikes this year and 3 more in 2019.  Ambitious fiscal spending, at this late point in the economic cycle, will support the Fed’s hawkish position.  The ballooning deficit, continued deficit spending and higher interest rates will raise the probability of a slowdown (recession) sometime in the near future. 

The other curiosity I’ve discussed before is the perpetual weakness in the US$.  It has been in a steady decline since the November 2016 election.  The higher interest rates available in the US would support buying dollars.  On the contrary, global investors have been selling US$s, and buying yen and euros.   It’s not clear what is causing this, though it’s likely related to increased tariffs, restrictive immigration and rising deficits.  The persistent US current account deficits are spurring talk the US$ may not be the safe-haven it once was.

The current backdrop is mixed.  Earnings estimates remain high and stocks are not excessively expensive with the forward P/E multiple in the 16x range.  Volatility has risen, making stocks harder to own.  From a contrarian perspective, this is constructive.  Yet, if the earnings forecasts falter, for whatever reason, this will spell trouble for stock prices.  With the high level of volatility, and two successive down months in stock prices, we are taking a more constructive stance, and will become more cautious if conditions persist.  Please feel free to call us if you would like to discuss further or if your investment parameters have changed since we last spoke.

Bruce Hotaling, CFA

Managing Partner

Mish Mash

Investor behavior has been by and large complacent.  The market commentary has been Pollyannaish.  The combined effect has been an extended period of positive returns and low volatility.  Stock prices, measured by the S&P 500, rose for 15 consecutive months, something they had not done in over 20 years.  Then, in February, stock prices fell by an uncomfortable 3.69%.  Sharp price drops, 4.1% on the 5th and 3.75% on the 8th, echoed swings felt prior to the onset of the financial crisis.

The market backdrop looks to have shifted.  A trend change cannot be extrapolated from one month’s returns.  Just the same, it may be that the majority of the market friendly changes (tax cuts, regulatory roll-back, loose spending) are baked in.  If this is the case, the return/risk profile stocks offer may have begun to seesaw.  Here are some observations worth your consideration.

The dominant factor influencing stock prices is earnings.  4Q 2017 was one of the strongest earnings seasons in the last 20 years, according to Bespoke Research. The “inflection” in earnings is remarkable, as they had been flat.  We tend to extrapolate data forward, and expectations going forward may be too high.

The surge in US corporate earnings has been bolstered by an up-swell in economic growth around the world.  Manufacturing PMI’s around the world are simultaneously rising, and although Europe’s emergence from the global debt crisis lagged, it’s now the catalyst for a full-fledged global economic revival.

Another boost to earnings has been a weakening US$.  This allows for a currency translation bump, when earnings from abroad are repatriated.  This tailwind has been in effect since November 2016, as the US$ has fallen roughly 15% against the Euro.

The current administration’s weak US$ policy is apparently intended to cure the trade deficit.  Curiously, the trade gap widened in January to the highest level since October 2008.  The recent imposition of tariffs on various imports may help offset the trade deficit but the true economic result will more likely be a decline in domestic growth – the opposite effect from the intended goal of making America great (protecting US industry).

The recent emphasis on fiscal policy and deficit spending is a significant concern at this point in the economic cycle.  It’s inflationary by definition, and the budget deficit may well exceed $1TN in 2018, something last accomplished in the dismal recovery from the financial crisis.  The looming cost of financing increased government debt levels is a large reason for the sharp increase in longer term interest rates.

Wages are also going up, which is good for workers earning the $7.25 federal minimum wage, but this too is a source of inflation.  Last month’s inflation data was the spark that ignited the February stock market sell-off.  The Fed has signaled it will raise rates three to four times in 2018.  Long term, there is a good likelihood the Fed (rising interest rates) will take the blame for triggering the next recession – not the ambitious policies that catalyzed the need for higher rates.

Finally, volatility is back.  This is a reflection of these disparate factors.  Stock prices move up and down and this normally tempers investor behavior.  When price volatility is low, investing in stocks becomes too easy.  The spike in volatility in February was only the second time the “fear” index hit those levels since the 2008 financial crisis.

Often times the stock market is not reacting to an event, as many TV commentators attempt to explain, rather it is signaling.  Stock prices are a leading indicator.  Along these lines, the sudden jump in price volatility (the VIX) may well be foreshadowing change.  The stock market may be telling us inflation is here and the Fed’s response will be to raise interest rates.  Four rate hikes may be the equivalent of taking away the punch bowl.  In my opinion, a raised level of caution is healthy here.  We have to be able to live with the ups and downs, and to do this may require owning less of the risky asset.  We have been repositioning portfolios to reduce oversized positions and address our view of the trend going forward.  If you would like to review this with us in more detail, please don’t hesitate to check in.

 

Bruce Hotaling, CFA

Managing Partner

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